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Debt, Equity and Dilution: What Investors Should Know




By Lisa Walls-Hester on 6th June 2016


Companies need cash to grow. Internal sources of working capital are usually only enough to sustain existing business operations so directors need to seek outside sources of capital to expand the business.

 

External capital can be in the form of debt or equity and the business must choose the most appropriate source of finance for a new project. The decision on debt or equity can impact a company’s future dramatically.

 

Should it be debt or equity?

 

Serial crowdfunders will be familiar with companies raising crowd equity claiming ‘We are crowdfunding to give our supporters and stakeholders the opportunity of co-owning the business.’ This may well be true for some businesses, but for most startups and small businesses selling equity is the only source of capital available to them.

 

Businesses prefer to raise debt finance – A survey (from Milken, Access to Capital  - How Small and Mid-Size Businesses are Funding Their Future) of over 600 small and medium enterprise (SME) owners in the U.S. found that debt is the preferred method of outside financing for SME’s. 

 

Debt finance is preferred because it is cheaper and quicker to raise than selling equity. The shorter the borrowing term the cheaper it is because lenders equate risk with time. The longer the loan term the more potential for things to go wrong with the business. Debt finance also means shareholders keep full ownership of the business.

 

Early-stage enterprises find it difficult to obtain debt finance because they have low and unpredictable cashflow to cover any loan repayments. In addition, most lenders also require loan collateral in the form of assets or future trading revenues which startups don’t have.

 

While raising equity finance takes longer and means business owners might have interference from shareholders there is no legal obligation for companies to pay out dividends to equity shareholders.

 

The Equity Funding Stages

 

Typically fledgling enterprises are funded by the entrepreneur and their friends and family. The following stages are Crowdfunding, Angel Investment and then Venture Capital.

 

Idea stage

One founder typically owns the idea and 100 percent of the enterprise.

 

Co-Founder Stage

Entrepreneurs usually try to recruit one or two co-founders who bring vital skills to the enterprise and will work for no salary but take a share of the enterprise. Founders typically own an equal share of the enterprise.

 

The Family and Friends Round

The enterprise needs funds to get going so the first port of call is the founder’s friends, family, and associated networks. It is at this stage in the enterprise’s evolution when founders typically form a company and may sell between 5 to 10 percent of the equity to friends and family.

 

Crowdfunding and Angels

Angel investments can be anywhere between £5,000 and £250,000. Angels invest their own cash so take more risks than venture capital firms. They tend to invest in more early-stage or seed start-ups and can often follow-up with later rounds of financing for the same company.

 

There is a trend to this upper limiting increasing with the growth of angel syndicates and a new breed of ‘super angels’ who typically invest larger amounts.

 

 Venture capital (VC) investment

VC investment tends to be in excess of £1million and they usually invest when there is a clear and defined route for growth.

VC firms invest through managed funds, which are raised with public or private money and they are bound by administrative restraints and a need to see a profitable return fairly quickly. VC’s are more focused on returns and exits.

For each round of new investment, existing shareholders will reduce their proportion of equity. It is referred to as dilution.

 

Dilution

For investors in early stage companies share or stock dilution is inevitable. But what is it and is it something that should be strike fear in the hearts of those investors that invested from the beginning?

 

Dilution is a reduction in proportional ownership caused when a company issues additional shares. 

 

It is a natural consequence of companies growing and needing more capital.

 

Illustrating Equity Investment Dilution Tool  

 

Existing shareholders have the right to purchase new shares in proportion to their existing holding. This is known as pre-emption rights. Anti-dilution provisions can also be referred to as subscription rights.

 

Pre-emption rights is an obligation that requires a company to offer existing shareholders the option of buying additional shares to maintain their percentage holding prior to making the offer available to new investors.

 

In early-stage investing, business angels and syndicates of investors consider pre-emption as one of the basic investor protections and will not invest without this right.  Venture Capital contracts often contain an anti-dilution provision in favour of the original investors, to protect their equity investments.

 

Dilution can alter not only the ownership percentage but voting control, earnings per share, and the value of a share.

 

Voting dilution - A large issue of shares to new investors could alter the voting control of a business. If the founding owners hold over 50 percent of the equity they may be reluctant to sell new shares to outside investors as their control of the business could be lost.

 

Earnings dilution – The amount of profits available for distribution is reduced as the number of the total number of shares is increased.

 

Value dilution - Value dilution describes the reduction in the current price of a stock due to the increase in the number of shares. This generally occurs when shares are issued in exchange for the purchase of a business, and incremental income from the new business must be at least the return on equity of the old business. 

 

Experienced entrepreneurs often take a strategic outlook about the financing of the company and set out the funding route map for investors from the beginning. This transparency about financing and the need for future capital helps early investors in their decision to invest in a company because any dilution is delineated.

 

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